New Classical Macroeconomics Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University

New Classical Macroeconomics “Keynesian orthodoxy or the neoclassical synthesis is in deep trouble, the deepest kind of trouble in which an applied body of theory can find itself. It appears to be giving seriously wrong answers to the most basic questions of macroeconomic policy.” - Robert E. Lucas, Jr., “Tobin and Monetarism: A Review Article,” JEL (June 1981)

New Classical Macroeconomics Evolved out of monetarist economics of 1970s Evolved out of monetarist economics of 1970s Major proponents Major proponents Robert E. Lucas, Jr. Robert E. Lucas, Jr. Thomas Sargent Thomas Sargent Robert Barro Robert Barro Edward Prescott Edward Prescott Neil Wallace Neil Wallace Patrick Minford Patrick Minford

New Classical Macroeconomics Three Central Hypotheses Three Central Hypotheses 1. Rational Expectations Hypothesis 2. Continuous Market-Clearing Hypothesis 3. Aggregate Supply Hypothesis Each can be judged in isolation Each can be judged in isolation New Classicalists accept all three New Classicalists accept all three

Rational Expectations Rational expectations hypothesis (at least in weak form) becomes a central modeling assumption of the dominant schools in the 1990s and this century Rational expectations hypothesis (at least in weak form) becomes a central modeling assumption of the dominant schools in the 1990s and this century Real Business Cycle School Real Business Cycle School New Keynesian School New Keynesian School Rhetorical advantage of rational expectations Rhetorical advantage of rational expectations

Continuous Market-Clearing All markets continuously clear in line with Walrasian view All markets continuously clear in line with Walrasian view Agents and Firms are price-takers Agents and Firms are price-takers Observed outcomes result of optimal responses of agents to price perceptions Observed outcomes result of optimal responses of agents to price perceptions New Classical Models are equilibrium models New Classical Models are equilibrium models

Continuous Market-Clearing New Classical equilibrium New Classical equilibrium Equilibrium means that agents have optimally responded to price signals based on existing demands and supplies Equilibrium means that agents have optimally responded to price signals based on existing demands and supplies Demands and supplies are based on expectations Demands and supplies are based on expectations Lack of complete information can lead to expectational errors and equilibria that are not identical to the full-information equilibria Lack of complete information can lead to expectational errors and equilibria that are not identical to the full-information equilibria

Continuous Market-Clearing New Classical equilibrium New Classical equilibrium Prices always adjust to clear markets Prices always adjust to clear markets “instantaneous price adjustment” “instantaneous price adjustment” Does not imply that market-clearing prices are prices consistent with full- information equilibrium Does not imply that market-clearing prices are prices consistent with full- information equilibrium Prices can clear markets but still be “wrong” Prices can clear markets but still be “wrong”

Continuous Market-Clearing New Classical equilibrium New Classical equilibrium Implies that unemployment is always entirely voluntary Implies that unemployment is always entirely voluntary Most critical and contentious of new classical hypotheses

Aggregate Supply Two main approaches Two main approaches Both share two orthodox micro assumptions Both share two orthodox micro assumptions 1. Workers’ and Firms’ decisions are maximizing or optimal 2. Supply decisions of workers and firms depend upon relative prices

Lucas-Rapping ASH Lucas, R.E., Jr., and Rapping, L., “Real Wages, Employment and Inflation,” Journal of Political Economy (Sept./Oct. 1969) Lucas, R.E., Jr., and Rapping, L., “Real Wages, Employment and Inflation,” Journal of Political Economy (Sept./Oct. 1969) Essence: during any period, workers must decide how much time to allocate between work and leisure. Essence: during any period, workers must decide how much time to allocate between work and leisure.

Lucas-Rapping ASH Workers have notion of “normal” average real wage. Workers have notion of “normal” average real wage. Workers intertemporally substitute leisure over the course of their lifetimes. Workers intertemporally substitute leisure over the course of their lifetimes. When w > w e, workers work more and take less leisure When w > w e, workers work more and take less leisure When w < w e, workers work less and take more leisure When w < w e, workers work less and take more leisure

Lucas-Rapping ASH Employment is always at the voluntary and optimal level. Employment is always at the voluntary and optimal level. Changes in employment reflect the voluntary choices of labor due to changes in relative real wages over time. Changes in employment reflect the voluntary choices of labor due to changes in relative real wages over time.

Lucas ASH Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory (April 1972) Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory (April 1972) Lucas, “Some International Evidence on Output-Inflation Tradeoffs,” AER (June 1973) Lucas, “Some International Evidence on Output-Inflation Tradeoffs,” AER (June 1973) Spirit: “Signal-Extraction Problem” Spirit: “Signal-Extraction Problem” Problem of information set available to agents Problem of information set available to agents

Lucas ASH “Signal-Extraction Problem” “Signal-Extraction Problem” Firms know current price of own output, but price level of other markets known only with lag. Agents must form expectations of prices elsewhere. Firms know current price of own output, but price level of other markets known only with lag. Agents must form expectations of prices elsewhere. Firm problem: if P x increases, does that mean D x has increased or AD has increased? Firm problem: if P x increases, does that mean D x has increased or AD has increased? If D x increased, then increase QS x If D x increased, then increase QS x If AD increased, then no change in QS x If AD increased, then no change in QS x

Lucas “Surprise” AS Function Both Aggregate Supply Hypotheses lead to notion that Y deviates from Y N due to deviations of P from P e (or deviations of dP from dP e ) Both Aggregate Supply Hypotheses lead to notion that Y deviates from Y N due to deviations of P from P e (or deviations of dP from dP e ) Y – Y N = α ( P – P e ) Y – Y N = α ( dP – dP e ) If P > P e (or P > P e ), then both workers and firms mistake nominal price changes as relative price changes If P > P e (or P > P e ), then both workers and firms mistake nominal price changes as relative price changes

Equilibrium Business Cycle Lucas saw himself as Lucas saw himself as Formally incorporating microeconomics into macroeconomic models Formally incorporating microeconomics into macroeconomic models Taking up the business cycle research agenda of Hayek – “incorporating cyclical phenomena into system of equilibrium theory” Taking up the business cycle research agenda of Hayek – “incorporating cyclical phenomena into system of equilibrium theory”

Equilibrium Business Cycle Central Thesis Unanticipated AD shocks (resulting mainly form unanticipated ∆M s ) ∆M s ) cause agents to make erroneous (rational) expectations, that result in Y and L deviations from (long-run) full- information equilibrium levels. Errors are result of imperfect/incomplete information, so general price changes are mistaken for relative price changes.

New Classical v. Orthodox Monetarism OM: Workers fooled by inflation, firms aren’t OM: Workers fooled by inflation, firms aren’t Adaptive expectations mean workers can be continuously fooled Adaptive expectations mean workers can be continuously fooled NC: Both workers and firms can be fooled by inflation NC: Both workers and firms can be fooled by inflation Rational expectations mean agents can only be fooled by surprises Rational expectations mean agents can only be fooled by surprises Both: Once agents realize errors, Y and L return to long-run (or full-information) equilibrium Both: Once agents realize errors, Y and L return to long-run (or full-information) equilibrium

New Classical Business Cycle In New Classical Approach, deviations from long-run equilibrium are due to random shocks which cause errors in price expectations. In New Classical Approach, deviations from long-run equilibrium are due to random shocks which cause errors in price expectations. Why are shocks necessarily random? Why are shocks necessarily random? Ratex implies expectational errors are random. Ratex implies expectational errors are random. Ratex and ASH imply Y and L fluctuate randomly around Y N and L N. Ratex and ASH imply Y and L fluctuate randomly around Y N and L N.

New Classical Business Cycle Unemployment and output deviate from natural levels due to: Unemployment and output deviate from natural levels due to: 1. Demand shocks 2. Supply shocks 3. Monetary surprise

New Classical Business Cycle Further assumptions required to explain persistence of deviations of Y and L from trend values during business cycles. Further assumptions required to explain persistence of deviations of Y and L from trend values during business cycles. Lagged output and durability of capital goods. Lagged output and durability of capital goods. Labor contracts inhibiting immediate adjustment. Labor contracts inhibiting immediate adjustment. Adjustment costs. Adjustment costs.

Policy Implications 1. Policy Ineffectiveness Proposition 2. Output-Employment Costs of Reducing Inflation 3. Dynamic Time Inconsistency, Credibility and Monetary Rules 4. Central Bank Independence 5. Role of Micro Policies to Increase AS 6. The “Lucas Critique” of Econometric Policy Evaluation

Policy Ineffectiveness “Monetary authorities are unable to influence output and employment, even in the short-run, by pursuing systematic monetary policy.”

Policy Ineffectiveness Agents form rational expectations. Agents form rational expectations. If monetary authorities are following a systematic policy, agents will come to know the policy and its effects. If monetary authorities are following a systematic policy, agents will come to know the policy and its effects. Agents will on average correctly anticipate the actions and effects of monetary policy. Agents will on average correctly anticipate the actions and effects of monetary policy. Deviations from full employment output are result of surprise. Deviations from full employment output are result of surprise. Therefore, systematic policy can not affect output and employment. Therefore, systematic policy can not affect output and employment.

Policy Ineffectiveness Expansionary monetary policy shifts AD to right. Expansionary monetary policy shifts AD to right. If unexpected, workers and firms act as if increase in P is increase in relative prices and output increase beyond Y N to Y*. If unexpected, workers and firms act as if increase in P is increase in relative prices and output increase beyond Y N to Y*. As agents realize their mistakes, output returns to Y N as prices adjust to full- information levels. As agents realize their mistakes, output returns to Y N as prices adjust to full- information levels. P Y LRAS SRAS 0 AD 1 AD 0 SRAS 1 Y*YNYN P0P0 P1P1 P2P2

Policy Ineffectiveness Expansionary monetary policy shifts AD to right. Expansionary monetary policy shifts AD to right. If unexpected, workers and firms act as if increase in P is increase in relative prices and output increase beyond Y N to Y*. If unexpected, workers and firms act as if increase in P is increase in relative prices and output increase beyond Y N to Y*. As agents realize their mistakes, output returns to Y N as prices adjust to full- information levels. As agents realize their mistakes, output returns to Y N as prices adjust to full- information levels. If policy is expected, agents realize prices will rise to full- information level, P 2, and therefore no real changes occur. If policy is expected, agents realize prices will rise to full- information level, P 2, and therefore no real changes occur. P Y LRAS SRAS 0 AD 1 AD 0 SRAS 1 YNYN P0P0 P2P2

Corollary “Attempts to affect output and employment by random monetary policy only increases the variation of output and employment around the natural levels.”

Policy Ineffectiveness Empirical Tests Empirical Tests Early work of Barro supportive of New Classical Theory and the policy ineffectiveness proposition Early work of Barro supportive of New Classical Theory and the policy ineffectiveness proposition Subsequent studies by Mishkin and Gordon find counter evidence Subsequent studies by Mishkin and Gordon find counter evidence

Output-Employment Costs of Reducing Inflation Sacrifice ratio = amount of lost output per percentage point reduction in inflation Sacrifice ratio = amount of lost output per percentage point reduction in inflation Orthodox Keynesians: sacrifice ratio large owing to sluggish response of prices and wages to reduced AD Orthodox Keynesians: sacrifice ratio large owing to sluggish response of prices and wages to reduced AD

Output-Employment Costs of Reducing Inflation Orthodox Monetarists: sacrifice ratio dependent upon Orthodox Monetarists: sacrifice ratio dependent upon (1) degree of monetary contraction (2) extent of institutional adaptations (3) rate of expectations adjustment Rate of expectations adjustment depends upon credibility of monetary authority Rate of expectations adjustment depends upon credibility of monetary authority

Output-Employment Costs of Reducing Inflation New Classical: an announced credible monetary contraction leads to immediate reduction of inflationary expectations and sacrifice ratio is 0! New Classical: an announced credible monetary contraction leads to immediate reduction of inflationary expectations and sacrifice ratio is 0! Only monetary surprises have effect on real output and employment.

Monetary Growth Rules Friedman’s Case for Monetary Growth Rule Friedman’s Case for Monetary Growth Rule Informational constraints facing policymakers Informational constraints facing policymakers Lag and forecasting problems Lag and forecasting problems Uncertainty of size of fiscal and monetary multipliers Uncertainty of size of fiscal and monetary multipliers Accelerationist hypothesis Accelerationist hypothesis Distrust of political process Distrust of political process

Dynamic Time Inconsistency Kydland and Prescott, “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy (June 1977) Rigorous New Classical model where policymakers are engaged in strategic dynamic game with rational private sector agents Rigorous New Classical model where policymakers are engaged in strategic dynamic game with rational private sector agents

Dynamic Time Inconsistency  Time-inconsistency: the divergence between ex ante and ex post optimality of government fiscal/monetary policy Time-inconsistency weakens credibility of announced policies; Time-inconsistency leads to an inflationary-bias in discretionary policy

Dynamic Time Inconsistency The Model Policymakers (1) specify targets (2) identify SWF w/ targets as arguments (3) choose policy s.t. SWF is maximized Private Agents Anticipate and adjust to policy Social Welfare Function S t = f(U t, dP t ) with SRPC constraint

Dynamic Time Inconsistency A time-consistent policy is one that maximizes S s.t. constraint and is consistent with agent full-information adjustment A time-consistent policy is one that maximizes S s.t. constraint and is consistent with agent full-information adjustment Points on vertical axis (LRPC) are potential equilibria Points on vertical axis (LRPC) are potential equilibria C is a time-consistent equilibria C is a time-consistent equilibria A is a time-inconsisent equilibria (why?) A is a time-inconsisent equilibria (why?) UNUN UtUt dP t dP e = c dP e = 0 0 C A

Dynamic Time Inconsistency Suppose at C (inferior or sub-optimal) Why? Suppose at C (inferior or sub-optimal) Why? Reduction of monetary growth from dM=C to dM = 0 will move economy directly to 0 if credible Reduction of monetary growth from dM=C to dM = 0 will move economy directly to 0 if credible Once at 0, superior position can be achieved through inflationary surprise to move to A Once at 0, superior position can be achieved through inflationary surprise to move to A But such a policy is time-inconsistent (why?) But such a policy is time-inconsistent (why?) UNUN UtUt dP t dP e = c dP e = 0 0 C A

Dynamic Time Inconsistency Policy Implications If monetary authorities have discretionary powers, they have an incentive to cheat If monetary authorities have discretionary powers, they have an incentive to cheat Since agents know this, announced policies that are time-inconsistent are not credible Since agents know this, announced policies that are time-inconsistent are not credible Discretionary policy produces sub- optimal outcomes with an inflationary bias Discretionary policy produces sub- optimal outcomes with an inflationary bias

Central Bank Independence If time-inconsistency argument is accepted, some constraint to discretion must be found If time-inconsistency argument is accepted, some constraint to discretion must be found Does central bank independence provide this? Does central bank independence provide this? Empirical evidence Empirical evidence greater independence reduces average inflation rate while having no effect on real performance greater independence reduces average inflation rate while having no effect on real performance Counterarguments Counterarguments Free banking and history of Fed Free banking and history of Fed Macroeconomic coordination Macroeconomic coordination

Micro Policies and AS Unemployment is equilibrium outcome of optimal decisions Unemployment is equilibrium outcome of optimal decisions Appropriate policy to reduce unemployment is to increase incentives for employment Appropriate policy to reduce unemployment is to increase incentives for employment Examples? Examples?

The “Lucas Critique” Lucas, “Econometric Policy Evaluation: A Critique,” in Brunner and Meltzer, ed., The Phillips Curve and Labor Markets (1976) Attacks practice of using large scale macro models to evaluate consequences of alternative policy scenarios Attacks practice of using large scale macro models to evaluate consequences of alternative policy scenarios

The “Lucas Critique” Such models are based on assumption coefficients don’t change with change in policy Such models are based on assumption coefficients don’t change with change in policy Economic agents will adjust behavior to new policy Economic agents will adjust behavior to new policy Empirics Empirics Models under-predicted dP in late 1960s and early 1970s Models under-predicted dP in late 1960s and early 1970s Direct tests: no strong support Direct tests: no strong support

Whose Critique? “There is first of all the central question of methodology, - the logic of applying the method of multiple correlation to unanalysed economic material, which we know to be non- homogeneous through time. If we were dealing with the action of numerically measurable, independent forces, adequately analysed so that we were dealing with independent atomic factors and between them completely comprehensive, acting with fluctuating relative strength on material constant and homogeneous through time, we might be able to use the method of multiple correlation with some confidence for disentangling the laws of their action… In fact we know that every one of these conditions is far from being satisfied by the economic material under investigation… ” - Keynes, “Professor Tinbergen’s Method,” Economic Journal (1937)

Distinguishing Beliefs (1) Economy inherently stable and erratic monetary growth is primary source of instability (2) No long-run tradeoff between inflation and unemployment; no short-run tradeoff from systematic monetary policy

Distinguishing Beliefs (3) Credibility of monetary authority primary determinant of fluctuations in output and employment (4) Discretionary monetary policy has time-inconsistent inflationary bias; rules are preferable (5) Fiscal policy has no effect on the economy, except to alter the natural levels of output and employment

Evaluation: Weaknesses New Classical macroeconomics argues that the Business Cycle is ultimately caused by information gaps Given low cost availability of price and monetary data, magnitude and duration of actual business cycles seem too big to reconcile Given low cost availability of price and monetary data, magnitude and duration of actual business cycles seem too big to reconcile Empirics cast doubt that only unanticipated changes in monetary policy have real output effects Empirics cast doubt that only unanticipated changes in monetary policy have real output effects

Evaluation: Lasting Impacts (1) Attention to modeling expectations (2) Focus on building macro models upon microeconomic foundations (3) Understanding that policy less robust than intimated by macroeconometric models